NASAA Series 66 Uniform Combined State Law ExaminationInvestment Vehicle CharacteristicsHard
An investor owns a bond with a 5% coupon rate, a par value of $1,000, and 10 years to maturity. If interest rates in the market suddenly rise to 7%, what is the MOST likely immediate effect on the bond's market price and its yield to maturity (YTM)?
- APrice remains unchanged, YTM increases
- BPrice decreases, YTM increases
- CPrice increases, YTM decreases
- DPrice decreases, YTM remains unchanged
Show answer & explanationAnswer & explanation
Correct answer: B. Price decreases, YTM increases
When market interest rates rise, newly issued bonds offer higher coupon rates. To make existing bonds with lower coupon rates competitive, their market price must fall. This decrease in price, combined with the fixed coupon payments, effectively increases the bond's yield to maturity (YTM) for new buyers.
Why the other options are wrong
- A. Bond prices will change in response to market interest rate changes.
- C. This describes the effect of falling interest rates.
- D. YTM will change as the bond's price changes relative to its fixed coupon payments.
Bond Price-Interest Rate Relationship
The inverse relationship between bond prices and market interest rates: when interest rates rise, bond prices fall, and vice versa.
- Inverse relationship
- Existing bonds' coupon rates are fixed
- Market price adjusts to align yield with prevailing rates
- Longer maturity bonds are more sensitive to rate changes
Memory trick: Interest rates and bond prices are like a 'seesaw'.